Chapter
20
Aggregate Demand and
Aggregate Supply
Aggregate Demand & Aggregate Supply
• Economic activity
– Fluctuates from year to year
• Economic fluctuation
– Business cycle
• Recession
– Economic contraction
– Period of declining real incomes and rising
unemployment
• Depression
– Severe recession
2
3 Key Facts About Economic Fluctuations
1. Economic fluctuations are irregular and
unpredictable
– i.e, fluctuations (around the trend) =
business cycles (booms/recessions)
2. Most macroeconomic quantities fluctuate
together
– GDP (growth rate) - Investment (I) –
Unemployment Rate (U) – Inflation (∏)
3. As output falls, unemployment rises
3
Economic “Fluctuations”
Irregular and Unpredictable
4
Economic “Fluctuations”
Irregular and Unpredictable
5
Figure 1
A look at short-run economic fluctuations (a)
This figure shows real GDP in panel (a), investment spending in panel (b), and unemployment
in panel (c) for the U.S. economy using quarterly data since 1965. Recessions are shown as
the shaded areas. Notice that real GDP and investment spending decline during recessions,
while unemployment rises.
6
Figure 1
A look at short-run economic fluctuations (b)
Note that real GDP and investment spending decline during recessions. Although I accounts
for only 15-20% of GDP; it accounts for 50% of the decline in GDP during a recession
7
Figure 1
A look at short-run economic fluctuations (c)
. Recessions are shown as the shaded areas. Notice that real GDP and investment spending
decline during recessions, while unemployment rises.
8
Explaining Short-Run Economic Fluctuations
• The assumptions of Classical economists
– Austrian school (Hayek, von Mises)
– Monetarists (Friedman, Univ of Chicago, “Fresh Water”)
• Classical dichotomy
– Separation of variables into
• Real variables
• Nominal variables
• Monetary neutrality
– Changes in the money supply
• Affect nominal variables
• Does not affect real variables
9
Explaining Short-Run Economic Fluctuations
• Classical Economist Focus on the “Long-Run”
– Classical theory holds
• Changes in money supply
– Affect prices, nominal interest rates and other
nominal variables
– Does not affect real GDP, unemployment, real interest
rates, or other real variables
10
4
The long-run aggregate-supply curve (Classical View)
Price
Level
Long-run
aggregate
supply
P1
1. A change
in the price
P2
level . . .
2. . . . does not affect
the quantity of goods
and services supplied
in the long run
Natural rate
of output
Quantity of Output
Classical View – Supply determines equilibrium (real Y -> thereby U)
11
Figure 11-5 Classical Theory and
Increases in Aggregate Demand
Explaining Short-Run Economic Fluctuations
• The reality of short-run fluctuations
• Short-run
– Assumption of monetary neutrality - no
longer appropriate (can affect real variables in
short-run due to sticky prices/wages or
“surprises”
– Real and nominal variables are highly
intertwined
– Changes in the money supply
• Can temporarily push real GDP away from its
long-run trend
13
Explaining Short-Run Economic Fluctuations
• Model of aggregate demand & aggregate supply
– Model that most economists use to explain
short-run fluctuations in economic activity
• Around its long-run trend
• Aggregate-demand curve
– Shows the quantity of goods and services
• That households, firms, the government, and
customers abroad
• Want to buy at each price level
– Downward sloping
14
Figure 11-7 Demand-Determined Equilibrium Real GDP at
Less Than Full Employment
Keynes assumed
prices will not fall
when aggregate
demand falls
Figure 11-8 Real GDP and the
Price Level, 1934–1940
6
Tradeoff between Inflation and Unemployment?
Annual data from 1961 to 1968 shows a negative relationship between inflation
and unemployment (inflation = stimulative monetary (M1) and fiscal (G) policy)
17
Explaining Short-Run Economic Fluctuations
• Model of aggregate demand & aggregate supply
• Aggregate-supply curve
– Shows the quantity of goods and services
• That firms choose to produce and sell
• At each price level
– Upward sloping (very different from Classical)
• Similar factors that shift micro-based supply curve
(input prices, technology) also shift AS curve
– E.g., OPEC oil prices
18
Figure 2
Aggregate demand and aggregate supply
Price
Level
Aggregate supply
Equilibrium
price level
Aggregate demand
Equilibrium
output
Quantity of
Output
Economists use the model of aggregate demand and aggregate supply to analyze economic
fluctuations. On the vertical axis is the overall level of prices. On the horizontal axis is the
economy’s total output of goods and services. Output and the price level adjust to the point
at which the aggregate-supply and aggregate-demand curves intersect.
19
The Aggregate-Demand Curve
• Why the aggregate-demand (AD) curve slopes
downward
• Y = C + I + G + NX
• Three effects:
– Wealth effect (C ): decrease in prices – consumable income
increases
– Interest-rate effect (I): need less money to buy goods ->
increase loanable funds -> interest rate decreases
– Exchange-rate effect (NX) -> dec in interest rate ->
depreciaion of $
• Assumption: government spending (G)
– Fixed by policy
20
Figure 3
The aggregate-demand curve
Price
Level
P1
1. A decrease
in the price
P2
level . . .
Aggregate demand
Y1
Y2
Quantity of Output
2. . . . increases the quantity of
goods and services demanded
A fall in the price level from P1 to P2 increases the quantity of goods and services demanded
from Y1 to Y2. There are three reasons for this negative relationship. As the price level falls, real
wealth rises, interest rates fall, and the exchange rate depreciates. These effects stimulate
spending on consumption, investment, and net exports. Increased spending on any or all of
21
these components of output means a larger quantity of goods and services demanded.
The Aggregate-Demand Curve
• Why the AD curve might shift
• Changes in consumption, C
– Events - change how much people want to
consume at a given price level
• Level of taxation (decrease in income taxes,
increases spendable income -> increase C)
• Decrease C: increase in the savings rate (marginal
propensity to save) during a recession
– Increase in consumer spending
• Aggregate demand - shift right
22
The Aggregate-Demand Curve
• Why the AD curve might shift
• Changes in investment, I
– Events - change how much firms want to
invest at a given price level
• Better technology
• Tax policy (tax credits for I, faster depreciation)
• Money supply, Federal Discount Rate, Budget
deficit/surplus
– Increase in investment
• Aggregate demand - shift right
23
The Aggregate-Demand Curve
• Why the AD curve might shift
• Changes in government purchases, G
– Policy makers – change government spending
at a given price level
• Build new roads
– Increase in government purchases
• Aggregate demand - shift right
– Or decreases in government purchases
• AD curve shifts left
24
The Aggregate-Demand Curve
• Why the AD curve might shift
– Decreases in government purchases
Costs of government sequester
• low 0.1 percent growth in personal income
attributed todefense furloughs, more than
650,000 workers,
– a 0.5 percent decline in government pay, reduced
wages by $7.7 billion that month,
– Without sequester, income growth would have been
closer to 1.2 percent.
25
The Aggregate-Demand Curve
• Why the AD curve might shift
– If it sequester were reversed, the non-partisan
Congressional Budget Office has estimated
that as many as 1.6 million jobs would be
added and GDP would get a boost of as much
as 1.2 percent. Even the deficit would be in
better shape if the cuts were undone.
26
The Aggregate-Demand Curve
• Why the AD curve might shift
• Changes in net exports, NX
– Events - change net exports for a given price
level
• Recession in Europe –decrease demand US goods
• International speculators – change in exchange
rate
– Increase in net exports
• Decrease in exchange rate; US goods cheaper
• Aggregate demand - shift right
27
The Aggregate Supply Curve
• Long run
– Aggregate-supply curve is vertical
• Short run
– Aggregate-supply curve is upward sloping
• Why the aggregate-supply curve (LRAS) is
vertical in the long run
– Price level does not affect the long-run
determinants of GDP:
• Supplies of labor, capital, and natural resources
• Available technology
28
Figure 4
The long-run aggregate-supply curve
Price
Level
Long-run
aggregate
supply
P1
1. A change
in the price
P2
level . . .
2. . . . does not affect
the quantity of goods
and services supplied
in the long run
Natural rate
of output
Quantity of Output
In the long run, the quantity of output supplied depends on the economy’s quantities of labor,
capital, and natural resources and on the technology for turning these inputs into output.
Because the quantity supplied does not depend on the overall price level, the long-run
aggregate-supply curve is vertical at the natural rate of output.
29
The Aggregate Supply Curve
• Why the LRAS curve might shift
• Natural rate of output
– Production of goods and services
– That an economy achieves in the long run
• When unemployment is at its normal rate
– Potential output
– Full-employment output
30
The Aggregate Supply Curve
• Why the LRAS curve might shift
– Any change in natural rate of output
• Changes in labor
– Quantity of labor – increases
• Aggregate supply – shifts right
– Natural rate of unemployment – increases
• Aggregate supply – shifts left
31
The Aggregate Supply Curve
• Why the LRAS curve might shift
• Changes in capital
– Capital stock – increase
• Aggregate supply – shifts left
– Physical capital
– Human capital
32
The Aggregate Supply Curve
• Why the LRAS might shift
• Changes in natural resources
– New discovery of natural resource
• Aggregate supply – shifts right
– Weather
– Availability of natural resources
33
The Aggregate Supply Curve
• Why the LRAS curve might shift
• Changes in technology
– New technology, for given labor, capital and
natural resources
• Aggregate supply – shifts right
– International trade
– Government regulation
34
The Aggregate Supply Curve
• Using AD and LRAS to depict long-run growth
and inflation
• In long run: both AD and LRAS curve shift
• Continual shifts of LRAS curve to right
– Technological progress
• AD curve shifts to right
– Monetary policy
– The Fed increases money supply over time
• Result:
– Continuing growth in output
– Continuing inflation
35
Figure 5
Long-run growth and inflation in the model of
aggregate demand and aggregate supply
Price
Level
2. . . . and
growth in the
money supply
shifts aggregate
demand . . .
1. In the long run, technological progress shifts long-run aggregate
Long-run
aggregate supply, supply…
LRAS1980
LRAS1990 LRAS2000
P2000
3. . . . leading to growth in output . . .
P1990
P1980
AD2000
4. . . . and
ongoing inflation
AD1980
Y1980
Y1990
AD1990
Y2000
Quantity of Output
As the economy becomes better able to produce goods and services over time, primarily because of technological
progress, the long-run aggregate-supply curve shifts to the right. At the same time, as the Fed increases the
money supply, the aggregate-demand curve also shifts to the right. In this figure, output grows from Y1980 to Y1990
and then to Y2000, and the price level rises from P1980 to P1990 and then to P2000. Thus, the model of aggregate
36
demand and aggregate supply offers a new way to describe the classical analysis of growth and inflation
The Aggregate Supply Curve
• Why the aggregate-supply (AS) curve slopes
upward in the short-run
– Basic Microeconomic Theory
– Increase in overall level of prices in economy
• Tends to raise the quantity of goods and services
supplied
– Decrease in level of prices
• Tends to reduce quantity of goods and services
supplied
37
Figure 6
The short-run aggregate-supply curve
Price
Level
Short-run
aggregate
supply
P1
1. A decrease
in the price
P2
level . . .
Y2
Y1
Quantity of Output
2. . . . reduces the quantity of goods and
services supplied in the short run
In the short run, a fall in the price level from P1 to P2 reduces the quantity of output supplied
from Y1 to Y2. This positive relationship could be due to sticky wages, sticky prices, or
misperceptions. Over time, wages, prices, and perceptions adjust, so this positive relationship is
only temporary.
38
The Aggregate Supply Curve
• Why the AS curve slopes upward in short-run
• Sticky-wage theory
– Nominal wages - slow to adjust to changing
economic conditions
• Long-term contracts: workers and firms
• Slowly changing social norms
• Notions of fairness - influence wage setting
– Nominal wages - based on expected prices
• Don’t respond immediately when:
– Actual price level – different from what was expected
39
The Aggregate Supply Curve
• Why the AS curve slopes upward in short-run
• Sticky-wage theory
– If price level < expected
• Firms – incentive to produce less output
– If price level > expected
• Firms – incentive to produce more output
40
The Aggregate Supply Curve
• Why the AS curve slopes upward in short-run
• Sticky-price theory
– Prices of some goods & services
• Slow to adjust to changing economic conditions
• Menu costs
– Costs to adjusting prices
41
The Aggregate Supply Curve
• Why the AS curve slopes upward in short-run
• Misperceptions theory
– Changes in the overall price level
• Can temporarily mislead suppliers
– About changes in individual markets
– Changes in relative prices
• Suppliers - respond to changes in level of prices
– Change - quantity supplied of goods and services
42
The Aggregate Supply Curve
• Why the AS curve slopes upward in short-run
• Quantity of output supplied =
= Natural rate of output +
+ a(Actual price level – Expected price level)
• Where a - number that determines how much
output responds to unexpected changes in the
price level
43
The Aggregate Supply Curve
• Why the short-run AS curve might shift
• Changes in labor, capital, natural resources,
or technological knowledge
– Shift the short-run AS curve
• Expected price level increases
– Aggregate-supply curve – shifts left
44
Table
2
The short-run aggregate-supply curve: summary (a)
Why Does the Short-Run Aggregate-Supply Curve Slope Upward?
1. The Sticky-Wage Theory: An unexpectedly low price level raises the real wage,
which causes firms to hire fewer workers and produce a smaller quantity of goods and
services.
2. The Sticky-Price Theory: An unexpectedly low price level leaves some firms with
higher-than desired prices, which depresses their sales and leads them to cut back
production.
3. The Misperceptions Theory: An unexpectedly low price level leads some suppliers
to think their relative prices have fallen, which induces a fall in production.
45
Table
2
The short-run aggregate-supply curve: summary (b)
Why Might the Short-Run Aggregate-Supply Curve Shift?
1. Shifts Arising from Labor: An increase in the quantity of labor available (perhaps due to a fall in the
natural rate of unemployment) shifts the aggregate-supply curve to the right. A decrease in the
quantity of labor available (perhaps due to a rise in the natural rate of unemployment) shifts the
aggregate-supply curve to the left.
2. Shifts Arising from Capital: An increase in physical or human capital shifts the aggregate-supply
curve to the right. A decrease in physical or human capital shifts the aggregate-supply curve to the
left.
3. Shifts Arising from Natural Resources: An increase in the availability of natural resources shifts the
aggregate-supply curve to the right. A decrease in the availability of natural resources shifts the
aggregate-supply curve to the left.
4. Shifts Arising from Technology: An advance in technological knowledge shifts the aggregate-supply
curve to the right. A decrease in the available technology (perhaps due to government regulation)
shifts the aggregate-supply curve to the left.
5. Shifts Arising from the Expected Price Level: A decrease in the expected price level shifts the shortrun aggregate-supply curve to the right. An increase in the expected price level shifts the short-run
aggregate-supply curve to the left.
46
Two Causes of Economic Fluctuations
• Assumption
– Economy begins in long-run equilibrium
• Long-run equilibrium:
– Intersection of AD and LRAS curves
• Output - natural rate
• Actual price level
– And: Intersection of AD and short-run AS
curve
• Expected price level = Actual price level
47
Figure 7
The long-run equilibrium
Price
Level
Equilibrium
price
Long-run
aggregate
supply
Short-run
aggregate
supply
A
Aggregate
demand
Natural rate
of output
Quantity of Output
The long-run equilibrium of the economy is found where the aggregate-demand curve crosses
the long-run aggregate-supply curve (point A). When the economy reaches this long-run
equilibrium, the expected price level will have adjusted to equal the actual price level. As a
result, the short-run aggregate-supply curve crosses this point as well.
48
Two Causes of Economic Fluctuations
• The effects of a shift in aggregate demand
• Wave of pessimism
– Affects aggregate demand
• Aggregate demand – shifts left
– Short-run
• Output falls & Price level falls
– Long-run
• Short-run aggregate supply curve – shifts right
• Output – natural rate
• Price level – falls
49
Table
3
Four steps for analyzing macroeconomic fluctuations
1. Decide whether the event shifts the aggregate demand curve or the
aggregate supply curve (or perhaps both).
2. Decide in which direction the curve shifts.
3. Use the diagram of aggregate demand and aggregate supply to determine
the impact on output and the price level in the short run.
4. Use the diagram of aggregate demand and aggregate supply to analyze
how the economy moves from its new short-run equilibrium to its long-run
equilibrium.
50
Figure 8
A contraction in aggregate demand
Price
Level
Short-run
aggregate
supply, AS1
Long-run
aggregate
supply
AS2
P1
3. . . . but over time, the
short-run aggregate-supply
curve shifts . . .
A
B
P2
C
4. . . . and output returns
to its natural rate.
P3
1. A decrease in
aggregate demand . . .
AD2
Y2
Aggregate demand, AD1
Y1
Quantity of Output
2. . . . causes output to fall in the short run . . .
A fall in aggregate demand is represented with a leftward shift in the aggregate-demand curve
from AD1 to AD2. In the short run, the economy moves from point A to point B. Output falls from
Y1 to Y2, and the price level falls from P1 to P2. Over time, as the expected price level adjusts,
the short-run aggregate-supply curve shifts to the right from AS1 to AS2, and the economy
reaches point C, where the new aggregate-demand curve crosses the long-run aggregate51
supply curve. In the long run, the price level falls to P3, and output returns to its natural rate, Y1.
Two big shifts in aggregate demand:
Great Depression and World War II
• Early 1930s: large drop in real GDP
– The Great Depression
– Largest economic downturn in U.S. history
– From 1929 to 1933
• Real GDP fell by 27%
• Unemployment rose from 3 to 25%
• Price level fell by 22%
– Cause: decrease in aggregate demand
• Decline in money supply (by 28%)
• Decreasing: consumer spending, investment spending
52
Two big shifts in aggregate demand:
Great Depression and World War II
• Early 1940s: large increase in real GDP
– Economic boom
– World War II
•
•
•
•
•
•
More resources to the military
Government purchases increased
Aggregate demand – increased 1939 - 1944
Doubled the economy’s production of goods and services
20% increase in the price level
Unemployment fell from 17 to 1%
53
Figure 9
U.S. real GDP growth since 1900
Over the course of U.S. economic history, two fluctuations stand out as especially large. During
the early 1930s, the economy went through the Great Depression, when the production of
goods and services plummeted. During the early 1940s, the United States entered World War II,
and the economy experienced rapidly rising production. Both of these events are usually
explained by large shifts in aggregate demand.
54
The recession of 2001
• 2001: Recession
– Unemployment rate
•
•
•
•
December 2000: 3.9%
August 2001: 4.9%
June 2003: 6.3%
January 2005: 5.2%
• Three events – decrease in aggregate demand
1. The end of dot-com bubble in stock market
• Stock prices fell (25%)
• Reduced consumer & investment spending
• Aggregate-demand curve - shifted to left
55
The recession of 2001
• Three events – decrease in aggregate demand
2. Terrorist attacks on September 11, 2001
• Stock market fell (12%) in one week
• Increased uncertainty about the future
• Aggregate-demand curve – shifted further to left
3. Series of corporate accounting scandals
• Enron and WorldCom
• Stock market fell
• Aggregate-demand curve – shifted further to left
56
The recession of 2001
• 2001: Recession
– Policymakers - quick to respond
– The Fed - expansionary monetary policy
• Interest rates fell; Federal funds rate fell
• Stimulated spending
– Congress
• Tax cut in 2001; Immediate tax rebate; Tax cut in 2003
• To stimulate consumer & investment spending
– Aggregate-demand curve – shifted to right
• Offset the three contractionary shocks
57
Two Causes of Economic Fluctuations
• The effects of a shift in aggregate supply
• Start: long run equilibrium
– Firms – increase in production costs
• Aggregate supply curve – shifts left
• Short-run
– Output falls & Price level rises
– Stagflation
• Long-run, if AD is held constant
– Short-run AS shifts back to right
– Output – natural rate
– Price level - falls
58
Figure 10
An adverse shift in aggregate supply
Price
Level
Long-run
aggregate
supply
AS2 1. An adverse shift in the short-run
aggregate-supply curve . . .
Short-run aggregate
supply, AS1
B
P2
3. . . . and
the price
P1
level to rise
A
Aggregate demand
Y2
Y1
Quantity of Output
2. . . . causes output to fall . . .
When some event increases firms’ costs, the short-run aggregate-supply curve shifts to the left
from AS1 to AS2. The economy moves from point A to point B. The result is stagflation: Output
falls from Y1 to Y2, and the price level rises from P1 to P2.
59
Two Causes of Economic Fluctuations
• The effects of a shift in aggregate supply
• Start: long run equilibrium
– Firms – increase in production costs
• Aggregate supply curve – shifts left
• Short-run
– Output falls and Price level rises
• Long-run
– Policymakers – shift AD to right
– Output – natural rate
– Price level – rises
60
Figure 11
Accommodating an adverse shift in aggregate supply
Price
Level
3. . . . which
causes the
price level
to rise
further . . .
Long-run
aggregate
supply
P3
P2
C
P1
A
AS2
1. When short-run aggregate
supply falls . . .
Short-run aggregate
supply, AS1
2. . . . policymakers can
accommodate the shift by
expanding aggregate demand . . .
AD2
Aggregate demand, AD1
4. . . . but keeps output
at its natural rate.
Y1
Quantity of Output
Faced with an adverse shift in aggregate supply from AS1 to AS2, policymakers who can influence
aggregate demand might try to shift the aggregate-demand curve to the right from AD1 to AD2.
The economy would move from point A to point C. This policy would prevent the supply shift from
reducing output in the short run, but the price level would permanently rise from P1 to P3.
61
Oil and the economy
• Economic fluctuations in the U.S. economy
– Since 1970
– Some: originated in the oil fields of the Middle East
• Some event - reduces the supply of crude oil
flowing from Middle East
– Price of oil - rises around the world
– Aggregate-supply curve – shifts left
– Stagflation
• Mid-1970s
• Late-1970s
62
Oil and the economy
• Some event – increases the supply of crude oil
from Middle East
– Price of oil decreases
– Aggregate-supply curve – shifts right
• Output – rapid growth
• Unemployment – falls
• Inflation rate – falls
63
Oil and the economy
• Recent years: World market for oil – not an
important source of economic fluctuations
– Conservation efforts
– Changes in technology
• 2008 - world oil prices – rising significantly
– Increased demand from a rapidly growing China
64